Coming to Grips with Risk

“I need to start taking more financial risks.”

Why?

“To make more money, you have to risk more money.”

This is a distilled conversation, but not an imaginary one. I’ve heard it countless times; every financial advisor or planner has. Clients declare that, in order to make more money, they need to take bigger investment risks to make it happen. The part that seems to elude people’s understanding is that you tend to make higher AVERAGE returns in the market with higher risk investment over a LONG period of time. The 2 most important words in that sentence are AVERAGE and LONG. Higher risk investments mean more volatility and potentially higher losses as well. Also, you have probably seen this sentence a hundred or more times: “Past performance does not guarantee future results.” It’s a disclosure that you will see in every investment prospectus because IT IS TRUE.

Whenever I hear someone tell me they want to be more aggressive with their portfolio, I have to ask why. What’s the reward, perceived or otherwise, from taking a larger risk with an investment? Is there an inherent value to risking more? And, most importantly, what is the acceptable level of risk the client is willing to take on for this goal?

Not easy questions.

It’s generally true that when we take more risks with investments, we can make more money over a longer period of time. The confusion here comes from one of probabilities: the client sees the possibility of a larger return on an investment as a guaranteed return, when that is quite far from the case.

I always ask why the risk tolerance has changed for the client. What made them want to switch to an aggressive, riskier portfolio? Has their risk tolerance increased? Have they recently inherited some money, or otherwise come into funds they didn’t previously have? If they say they are behind on their savings, I advise them to increase their investments each month to account for it rather than increasing their risk. One of the worst mistakes that an investor can make is to take on too much risk. It’s easy to be happy when your investment account balance is up. But, what do you do if it’s down? If you’ve taken on more risk than you can handle, you might panic and sell when the balance is down, thus locking in your losses. There is a cognitive bias called risk aversion bias. It states that we react about twice as strongly to a loss as we do to a gain. There are plenty of studies that show that it is highly unlikely that anyone can consistently “time” the market. I find that people tend to underestimate risk when the market is up and overestimate risk when the market is down.

But sometimes there is a value in taking on more risk. With enough time and smart investments, it is possible to see a greater return from a greater risk; an aggressive portfolio can prove to be the best choice in several instances. Part of my job is helping the client determine when and where an investment should be made, and how it can be done for the best possible returns. What is the time frame for this investment, and what is the expected yield? What are the ultimate goals, and how can we gauge the level of success from not only the investment itself, but from the risk/reward balance we inevitably factor in?

Risk is, in this usage, any uncertainty that has the possibility to negatively affect your finances. There are many different kinds of defined risk, ranging from things like inflation, volatility, or economic conditions (market risk), to corporate decisions that affect the investments you have (business risk). Investments outside the country or contingent on larger socio-cultural factors can be classified as political risks. Uncertainty around investments involving foreign money can be classed as currency risk.

There is a risk to not diversifying investments, or keeping all the eggs in a single basket, which is classified as a concentration risk. Any risks involving the ability to get your money out of investments is called a liquidity risk. Volatility, inflation, interest, credit and defaults, and the risk that a contracted party might default on an obligation (counterparty risk) are all uncertainties that can affect financial stability. As you can see, there is no shortage of financial risk in the world, ranging from small to large.

Understanding risk regarding investments means understanding the risk-return tradeoff. This is a principle that associates higher levels of risk with higher possibilities of return. Lower risk, lower return, by the same standard. The risk-return tradeoff means an investor seeking higher profits has to also accept a higher possibility of losses. Where an investor and their investments fall on this line is their measure of risk tolerance.

Some high-risk investment options include:

  • Initial Public Offerings (IPOs)
  • Foreign Emerging Markets
  • High Yield Bonds
  • Currency Trading
  • Penny Stocks
  • Leveraged Exchange-Traded Funds (ETFs)
  • Venture Capital (VC)
  • Financial derivatives
  • Oil and gas investments

Many of those are classified as high-risk-high-return because of instability and great uncertainty. An IPO, for instance, can make an individual a lot of money. But many companies have had IPOs and still went under. In the dotcom bubble of the late 1990s, for instance, many internet companies rose and fell in a matter of weeks to months, losing their investors untold millions in the process. Those with venture capital funds invested can also see their claims wither away as the product or service never takes off.

There are many different tricks, tips, hacks, and spins to try and make an investment work, or to figure out what to expect from any financial input. Many investors follow the Rule of 72, which is an easy way to calculate the length of time it’ll take to double your money. Take the number 72 and divide it by the growth rate you hope to earn. That number gives you the rough amount of years it’ll take to double your investment. This is a useful metric for approximating compounding periods.

We hear about startups ranging from Facebook to Snapchat making billions for their owners overnight because of IPOs or options. We see billionaires who are worth many times the GDP of small countries because of money on paper in the form of stock ownership or assets. This makes the nature of high-risk-high-return investment all the more attractive. Bet big to win big, it goes.

On the flip side, some lower risk investments include:

  • Corporate bonds
  • Savings bonds
  • Treasury bills, notes, bonds, and TIPS (Treasury Inflation-Protected Securities)
  • Dividend-paying stock
  • CDs (certificates of deposit)
  • High-yield savings accounts
  • Money market funds

These are all low-risk investments because they are based on stability, and in some cases they are backed by the Federal Deposit Insurance Corporation (FDIC), ensuring there is a backup in case the market encounters problems. Money market investments held at banks, for instance, have risk levels that are practically nonexistent because they come with FDIC insurance of up to $250,000 per institution, per investor. Online high-yield savings accounts aren’t traditional brick-and-mortar institutions, but they are FDIC-insured and have a nice APY (annual percentage yield).

Treasury bills, bonds, and notes are essentially small loans you give to the United States, backed by “the full faith and credit of the U.S. Government.” You purchase them for the face value, and you earn an annual interest rate. There are different rates of being paid back, which varies from notes to bills to bonds. But these are incredibly safe and easy investments that can yield a decent profit.

There are many types of risk and investment propositions. Very low risk with very low return investments are things like fixed and indexed annuities and insured municipal bonds. Some mid-spectrum investments, such as moderate-risk-moderate-return or medium-risk-medium-return, include preferred (i.e., convertible preferred, participating preferred) and utility stocks, equity mutual funds, blue-chip stocks, and residential real estate. Higher risks tend to be investments in technology or energy. Investments higher than high-risk are considered speculative, as the uncertainty is too great to gauge a realistic outcome and the focus is on price fluctuations.

There is no shortage of investment options, nor is there any shortage of risk variations for an individual or a business. Businesses, for example, can also face supply chain and model risks, as well as operational and bank risks. Those who look to start a company usually undertake a high-risk-high-return venture, although, depending on the nature of the business, it can often be classified as speculative. But for those with a passion and a dream to do something, the nature of the risk is secondary to the goal of achieving their vision. In these cases, risk evaluation and tolerance can be treated differently than an investment in, say, treasury bonds or savings accounts.

In any investment portfolio, it’s important to have a level of diversification to protect investments. You want to invest enough to cover potential losses, and you want to strike a balance between high-risk, medium-risk, and low-risk investments. Only low-risk investment portfolios likely won’t pay off the way the investor wants. Conversely, only high-risk investing means the investor can lose everything and have nothing to show for it.

This is a key area where financial advisors come in handy: we help analyze the nature of the investment crossed with the risk-return tradeoff and tolerance level to figure out which options are best for you. Factoring in your life goals, such as retirement, helps give us a clearer picture of what is preferable and what is inadvisable. You don’t want to be out your life savings on a risky gamble at age 55, for example. And you don’t need to only buy treasury and savings bonds at age 30. Moderating those levels and finding your place on the risk tradeoff is what we do.

With the right financial advisor to help guide your decisions, and with a realistic appraisal of what is feasible and desirable, you can match your level of risk with your level of return and achieve life goals responsibly and efficiently. No matter your financial situation or your level of desired risk, there are always investments that can be made to ensure a higher-quality future for you and your family. Taking big risks doesn’t mean you’ll automatically make more money. But understanding risk and rising to meet your needs is always a good investment.

This educational, article is provided as a courtesy by Craig Willeke, Financial Advisor with Eagle Strategies LLC, A Registered Investment Advisor and a New York Life company. To learn more about the information or topics discussed, please contact Craig Willeke at craig@willekefinancialgroup.com.

Investments involves risks, fees and expenses and may be subject to taxation. These factors when taken into consideration can seriously alter calculated results.